Editor’s note: This article was first published in October 2013; the fiscal cliff and European crisis references and the description of Apple as the world’s most valuable company reflect that period. Emilio Botín, cited as Banco Santander’s chairman, held the post until his death in 2014.
If we forget about speculation, trading and trying to squeeze the stock market as if it were a casino, we are left with the investment approach that worked in the past and that is still the most profitable today: value investing. To practice it, we have to think like investors, not gamblers.
It is often said that today, thanks to technology, the internet and specialist stock market magazines, individual investors are better informed than ever. And yet, once again, many individuals keep buying at the top and selling at the bottom, while those who were making money 40 years ago are still making money today.
So a shortage of information isn’t the problem, but a lack of knowledge is, as is the information overload that leads us nowhere. The advice any professional investor would give us is always the same: forget about market noise, fiscal cliffs, the European crisis and even market volatility, because none of that matters if we focus solely on the company we want to buy.
What are some of the principles of value investing?
1. The risk is not in volatility. Volatility is where the opportunity lies.
Investors are usually advised against investing in a volatile market, since it is considered risky. Historically, however, what should worry us is the absence of volatility, because it is low volatility combined with high stock valuations that has preceded the most severe crises.
High volatility, on the other hand, is what allows us to buy shares below their value. Basically, it is about buying on the dips, not on the rallies.
A trader buys when a stock breaks through a resistance level on the way up. A long-term investor springs into action when a stock breaks through a support level on the way down. Simply investing for the long term completely changes the rules of the game, a game that over the long run is far more profitable than short-term speculation, and the historical returns of value-investing portfolios leave no room for doubt or debate on this point.
2. Value and price.
“Price is what you pay; value is what you get” (Warren Buffett). Stock prices fluctuate constantly. Sometimes they shoot up excessively, and at other times they plunge, although nowadays practically every stock carries a speculative price based on future earnings. In other words, practically every stock is overvalued to begin with, regardless of its market price. Some will meet market expectations while others will disappoint, with the corresponding consequences for their prices.
That’s why it is a serious mistake to study only prices and charts, because they don’t show us the value of the company. To analyze a company’s value, you have to study the company closely, along with its sector and its position within the industry. If we choose a company that leads its market and has growth potential, one that competitors will find very hard to knock off its leading position, then over the long term, as its sales and profits grow, its price will rise.
Likewise, when we analyze a company’s value, we shouldn’t just study what the company is today, but what it will be tomorrow. Example: Microsoft and Apple.
In 1996, both companies were competing for leadership in personal computers. Many investors, after analyzing both companies, saw clearly that Microsoft would be the winner, and they were right. But it was very hard to know that, in the end, the most profitable move would have been to invest in Apple: it lost the PC battle, but it was more visionary and innovative than its rival and brought to market the products that made it the most valuable company in the world. That’s why, when you analyze a company’s value, its team and its management are part of that value.
3. What is investing really, and what am I buying?
Incredible as it may seem, when we ask someone what investing in the stock market is, they rarely give the right answer. Once you understand what it means to invest in a listed company, the way you invest will change.
Investing in the stock market is like going into business with someone else as partners. You are literally buying part of the company, so you become a “partner” in that company and share in its profits and/or losses.
It is a way of starting a business without having to run it, and for that reason you will put your money in the hands of someone who knows how to manage it properly so that it earns you a profit. If you invest in Banco Santander, Emilio Botín will be working for you and paying you part of the profits through dividends, so look for a company you would like to be part of. If over time you manage to build a large fortune, you can acquire a minority or majority stake in a company and take decisions in that company together with your fellow shareholders.
That’s why people often say you shouldn’t invest in a business you don’t understand. If you don’t know exactly what the company does, you are investing blind. And I don’t mean knowing that your company sells “wind turbines”, but knowing exactly who its biggest rivals are, its strengths and weaknesses compared with the competition, and the demand within the industry. In other words, doing a SWOT analysis on it as if you were going to open your own business. That should come first, even before you start analyzing the P/E ratio, EPS and so on.
4. What matters is when you buy, plus passive investing.
Many of the investors who learned from Benjamin Graham share the same message: Graham taught them to buy so cheaply that, whatever happened, they could sleep soundly.
When we invest in the stock market, rather than having an exit strategy (which you also need), the most important thing is to find the ideal moment to buy into the stock we want. A good entry into the market gives you added peace of mind, and that is what we would call a margin of safety. Although the concept is somewhat more complex, it comes down to buying a company after a heavy beating, both of the company in particular and of the market in general, which could give us the chance to buy “at a discount”.
Once you have bought the shares at a good price, the idea is to stay detached from all that market noise by adopting a “passive investment strategy”, which will keep us from making the mistake of selling on bad news and buying on good news. If anything, long-term investors average down during major declines.
(Read: Charlie Munger’s investing lessons: active or passive investing?)
5. Diversification is not your ally.
Most individual investors have heard that you have to diversify, and that this lowers your risk. In theory that should be the case, but in practice it rarely is, quite apart from the need to understand what proper diversification means.
In the past, people talked about diversifying across several stock markets and putting some fixed income in our portfolios. Today, with globalization, if there is a problem in the US, owning shares in Asia generally won’t protect you, just as a European diversifying into American markets because of doubts about Europe may find that Wall Street is also hit by Europe’s troubles.
Over-diversifying is what wipes out our portfolio’s returns, because diversifying sometimes means opening opposing positions (if option A falls, option B rises, and vice versa). It is like betting on a Real Madrid–Barcelona football match and saying: “I’m going to bet €100 that Madrid wins, but I’ll bet another €100 on Barcelona in case Madrid loses“.
As Warren Buffett said, diversification is a way of protecting yourself against ignorance, so the most profitable approach is to study a few companies and concentrate the capital we have set aside for investing in those few companies we want to be part of.
Further reading
- Probably the mother of all stock market investing mistakes
- What I learned from Keynes about investing
Featured image: Benoît Prieur, CC0 1.0, via Wikimedia Commons.
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